Blog

2018

A Brief Overview of Accounting Conventions

ACCOUNTING CONVENTIONS

The term 'accounting conventions' includes those customs or traditions which guide the accountant while preparing books of accounts. Conventions provide a standardized methodology that acts as a reliable means to compare financial results of different years. Accordingly, accounting conventions govern how companies and people prepare financial reports.

There are four accounting conventions which are accepted and followed worldwide:

  1. Consistency
  2. Disclosure
  3. materiality
  4. Prudence / conservatism

 

Consistency:

It is important that accounting practices for similar transactions are followed consistently and continuously across different financial years. If frequent changes take place in accounting practices, it becomes difficult to compare financial statements of different years. For example, if an organisation chooses cost or market price whichever is lower method for stock valuation and written down value method for depreciation to fixed assets, it should follow the same methods consistently across financial years.

As per this convention once an organisation chooses one method, it should use the same method for all subsequent events of the same nature unless there is a sound reason to change methods.

However, this convention does not imply inflexibility in accounting methods. It does not forbid improvement in accounting techniques. Consistency also states that if a change becomes necessary, the change and its effects on profit or loss and on the financial position of the company should be clearly mentioned.

Disclosure:

The main purpose of financial statement is to reflect the true and fair financial position of an organisation to all stakeholders. Hence, all the concerned stakeholders must be provided all details which may be necessary for proper interpretation of financial statement. Full disclosure may be made in the financial statement itself or as foot notes at the end of financial statements. Similarly, if there are any events occurring after preparation of financial statement but before it is published, the same must be communicated as foot notes.

The idea behind this convention is that anybody who want to study the financial statements should not be mislead. He should be able to make a free judgment. The disclosures can be in the way of foot notes, within the body of financial statements, in the minutes of meeting of directors etc.

Materiality:

The term materiality implies the relative importance of an item or an event. An accounting item or event is "material" if knowledge of such event might reasonably influence the decisions of users of financial statements. Accountants must make sure that all event which may be material to the stakeholders are properly reported in the financial statement. However, the concept of materiality also implies that the accounting process should be cost-effective. This means, the value of an accounting event should not exceed the cost of its preparation. In short, the convention of materiality allows accountants to ignore other accounting principles with respect to items that are not material. An example of the materiality convention is found in the manner in which most companies account for low-cost plant assets, such as stationery, waste baskets etc. Although the matching concept requires that depreciating must be charged on such plant assets over their useful life, these low-cost items usually are charged immediately to an expense account. It is also due to materiality convention that financial statements usually show amounts rounded to the nearest rupees.

Prudence / Conservatism:

It is a policy of playing safe. This convention recommends that uncertainties and risks involved in business transactions must be given a proper consideration. If there is a possibility of loss, it should be taken into consideration at the earliest. On the other hand, possibility of profit / gain must be ignored until it does not arise. Due to this convention, the accountants follow the rule ‘anticipate no profit but provide for all possible losses’. Under this policy, provisions are made for doubtful debts as well as contingent liability; but we do not consider any anticipatory gain.


It is due to this convention, the inventory is valued ‘at cost or market price whichever is less.’ The effect of the above is that in case market price has gone down then provide for the ‘anticipated loss’ but if the market price has gone up then ignore the ‘anticipated profits.’ Similarly a provision is made for possible bad and doubtful debt out of current year’s profits.

This convention is criticized by some as it goes against the convention of full disclosure. It encourages the accountant to create secret reserves (e.g. by creating excess provision for bad and doubtful debts, depreciation etc.). Due to this kind of practices, the financial statements do not show a true and fair view of state of affairs of the business.

Blog Archive


Financial Management